Depreciation explained

Depreciation is a critical concept in value investing, as it affects the reported earnings of a company, the valuation of its assets, and ultimately, the intrinsic value calculation that value investors rely on.

Here’s a detailed framing of the concept:

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Depreciation: The Double-Edged Accounting Sword

Depreciation is one of the most misunderstood and, arguably, frustrating accounting principles for many business owners and investors. It represents a non-cash expense that spreads the cost of an asset over its useful life. While this might sound logical in theory, its practical implications can feel counterintuitive and even punitive.

The Problem with Depreciation

Imagine you run a company and purchase an asset—say, a piece of machinery—using cash generated from your business’s operations. You’ve already incurred the full cost of the asset upfront, yet accounting rules prevent you from deducting the entire expense in the year of purchase. Instead, you’re required to depreciate the asset over its useful life, which might be five years or more.

This creates a peculiar situation:

• Cash Outflow vs. P&L Impact: While you’ve already spent 100% of the cash, your Profit & Loss (P&L) statement only reflects 20% of the expense each year (assuming a 5-year depreciation schedule). This mismatch between cash flow and expense recognition can distort the true financial picture of your business.
• Recurring Cycle: When the asset’s useful life ends, you often need to replace it, starting the depreciation cycle all over again. This means you’re perpetually adding back depreciation in your cash flow statement while recognizing only a fraction of the expense in your P&L.

From a cash perspective, you’ve already borne the full cost. Yet, for accounting purposes, you’re forced to stretch that cost over several years, reducing your ability to immediately offset the expense against your revenues.

Why Warren Buffett Prefers Float

Contrast this with Warren Buffett’s favorite concept: float. In his insurance businesses, Buffett enjoys the luxury of receiving cash upfront in the form of premiums, which he can invest before claims are paid out. This creates a positive cash flow cycle:

• Money First, Expense Later: The insurance float allows the company to use policyholders’ money for investments before it incurs the expense of paying claims. This is the exact opposite of the depreciation model, where money is spent upfront and deducted gradually over time.

Float not only provides liquidity but also offers the opportunity to generate returns on the capital before it is needed. Buffett often highlights this as a cornerstone of his investment strategy, as it provides both flexibility and compounding opportunities.

The Frustration with Depreciation

For businesses that are capital-intensive, depreciation can feel like a drain on financial efficiency:

• It reduces taxable income more slowly than the cash outflow occurs.
• It creates a perpetual accounting gap between cash reality and book reality.
• It can obscure the true cost of maintaining and replacing assets over time.

While depreciation serves a purpose in aligning expense recognition with the revenue generated by an asset, it often feels at odds with the real-world cash flow dynamics of a business. This is why some entrepreneurs and investors view depreciation as a frustrating expense, particularly when compared to more favorable financial structures like float.

Rethinking Owner’s Earnings: A Pragmatic Approach

Owner’s earnings is often touted as a critical metric for evaluating a business’s true profitability and sustainability. Popularized by Warren Buffett, it is defined as:

Owner’s Earnings = Net Income + Depreciation and Amortization − Capital Expenditures (CapEx)

The rationale behind this formula is that depreciation and amortization (D&A) are non-cash expenses. Since they don’t directly impact cash flow, they are added back to net income. However, this approach assumes that depreciation accurately represents the capital expenditures required to maintain the business’s operational capacity, which isn’t always the case.

The Problem with Adding Back Depreciation

While D&A is a non-cash accounting entry, it reflects the wear and tear of assets over time. These assets will eventually need to be replaced or upgraded, often requiring significant cash outlays. Adding back D&A to net income can give a misleading picture of the cash available to the business owner, especially if CapEx needs are underestimated.

For instance:

• Depreciation ≠ Actual CapEx: Depreciation is based on accounting estimates, which may not align with the real-world costs of replacing or upgrading assets. In some industries, CapEx far exceeds the depreciation charge.
• Overestimating Cash Flow: Adding back D&A assumes that the business can indefinitely delay replacing its assets, which isn’t realistic for long-term operations.

A Simpler and More Realistic Approach

To better reflect the cash available to the owner, I prefer a more straightforward formula:

Owner’s Earnings = Net Income − Capital Expenditures (CapEx)

This method avoids the potential overestimation of cash flow by excluding D&A from the calculation entirely. Here’s why this approach makes sense:

1. Focus on Real Cash Outflows: CapEx represents actual cash spent on maintaining or growing the business. By subtracting CapEx directly from net income, this formula provides a clearer picture of the cash that remains after reinvesting in the business.
2. Avoids Assumptions: This method doesn’t rely on the assumption that depreciation aligns with CapEx needs. Instead, it uses the actual CapEx figure, which is a concrete and measurable cash outflow.
3. Better Alignment with Reality: For businesses with significant CapEx requirements, this approach ensures that the owner’s earnings reflect the true cash available after sustaining the business’s operations.

Why It Matters

The goal of calculating owner’s earnings is to understand how much cash a business generates that can be distributed to its owners without compromising its long-term viability. By focusing on Net Income − CapEx, this formula avoids inflating earnings with non-cash adjustments and paints a more conservative, yet accurate, picture of a business’s financial health.

In essence, this approach prioritizes cash reality over accounting conventions, providing a more grounded metric for evaluating a business’s true profitability and sustainability.

In Summary

Depreciation is an unavoidable reality for most businesses, but its mechanics can feel like an uphill battle. Unlike the “pay later” advantage of float, depreciation enforces a “pay now, deduct later” model that can strain cash flows and obscure the true cost of doing business. For those who admire Buffett’s approach, the allure of float lies in its ability to flip this dynamic, offering a stark contrast to the constraints of depreciation.